The economy, alleged to be poised on a knife edge with rising prices on one side and falling prices on the other, is about to take a deflationary nose dive.
Why? because of “overcapacity.” The quantity of goods being produced is too large for consumers’ demand, forcing businesses to go begging. In short, the U.S. economy is about to fall victim to its own burgeoning productivity.
Well, the Chicken Littles are right about one thing: Recent improvements in productivity have been putting downward pressure on product prices.
But the claim that this spells disaster for the U.S. economy is hopelessly birdbrained. First of all, deflation is not inevitable, notwithstanding the extent of improvements in productivity or the vigor of global competition.
The Federal Reserve remains as capable as ever of expanding the money stock, thereby placing upward pressure on prices. But even though the Fed has the power to halt a productivity inspired deflation, it should resist doing so.
Why? Because a general decline in prices linked to general improvements in productivity is economically beneficial.
Rising productivity means declining unit costs of production. A given amount of labor, capital, and natural resources yields more output than before.
When unit production costs fall, businesses can pass the lower costs on to consumers in the form of lower prices without sacrificing profits.
Suppose that the Acme Widget Co. used to produce 100 widgets a week and sell them for $100, or a dollar each.
After a productivity improvement, using the same inputs, Acme produces and sells 104 widgets. If it now sells the widgets for only 90 cents each, its total revenues and profits remain the same. Because unit production costs have fallen, the price per widget can be reduced painlessly.
Such “benign” price cuts are a normal part of economic activity, an aspect of the rivalrous quest for customers. Far from hurting producers, it helps them to compete more effectively.
Notwithstanding claims to the contrary, recent price cuts have resembled the widget price cut mentioned above.
According to recently released figures, U.S. productivity has been growing at a remarkable 4.5 percent annual rate, meaning that the general price level could have fallen by the same percentage rate without generally impairing producers’ revenues or profits, and without heralding any decline in consumer spending.
In fact, Fed‐supported money creation has prevented prices from falling much in response to productivity gains. Consequently, far from shrinking, the demand for goods has been rising steadily.